Mayor Kwame Kilpatrick accepts an award at the 2005 Bond Buyer's Deal of the Year event in New York. / Charles Seesselberg/The Bond Buyer

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Detroit Free Press Business Writer

More about the deal

Were the $1.44-billion pension deal and the pledge of casino tax revenue legal?

In 2009, in order to avoid an immediate payment to swap holders, the city pledged casino tax revenues as collateral. Was this a violation of the Michigan Gaming Control and Revenue Act, which prescribes the use of wagering taxes? If this proves to be illegal, this debt would now be unsecured debt, and these creditors would get pennies on the dollar. Legal considerations

■ Did any law authorize the city to create separate entities in order to borrow the money? ■ Michigan law prohibits borrowing more than 10% of the property value of the city. Certificates of participation were used as an alternate to issuing bonds as a way for the city to circumvent this borrowing restriction. ■ Did the pledge of casino tax revenue violate the Michigan Gaming Control and Revenue Act, which defines how revenue can be used? What’s at stake

■ A violation of the Michigan Gaming Control and Revenue Act would mean the city could shed $770 million in swap debt. ■ A ruling that the certificates of participation are illegal could wipe out $1.95 billion in debt. ■ The judge could approve the settlement and the city would pay UBS and Bank of America about 75 cents for every dollar of interest-rate swap debt they hold.

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If Judge Steven Rhodes allows it, Detroit could pay off two global banks that steered the city into a disastrous gamble in 2005 that backfired, inflating an already-overwhelming budget shortfall and jeopardizing the city’s access to casino tax revenue.

At issue is a 2005 deal engineered by then-Detroit Mayor Kwame Kilpatrick, UBS and Merrill Lynch-backed SBS Financial Products The city borrowed $1.44 billion in variable-rate debt to eliminate its unfunded pension liabilities. It was the financial equivalent of a Hail Mary pass that was not only intercepted but returned for a touchdown.

Getting rid of the debt could go a long way toward improving the city’s operating budget, but it would reward the banks — UBS and Bank of America, which since acquired Merrill Lynch — at the expense of other creditors, including retirees and bondholders.

A hearing on the issue, which was to begin Tuesday, was delayed at the city’s request as talks continued on possible alternative settlements.

This is one of the most complex and important elements in the city’s bankruptcy proceedings because, if emergency manager Kevyn Orr prevails, it would unlock about $180 million in annual casino tax revenue, enabling Orr to seek broader refinancing.

But it is highly controversial because Orr has offered to pay UBS and Bank of America at least 75 cents on the dollar while other creditors may receive as little as 10 cents on the dollar and city retirees’ pensions could be cut.

Complicating matters is that Orr acknowledges the banks might not deserve special treatment legally, yet he still plans to pay them off instead of pursuing a potentially costly legal battle to challenge their rights.

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The deal involved two layers of speculative financial instruments. One layer involved “pension obligation certificates of participation” — essentially IOUs that allowed Detroit to borrow money to give to its two pension funds.

The second layer involved interest rate swaps, a high-risk bet that Detroit lost. The certificates of participation carried a variable interest rate. So the city bought the swaps as a hedge against the risk that interest rates would rise. In fact, interest rates fell sharply during the 2008-09 financial crisis. The city lost the bet, adding to the pensions’ underfunding by as much as $770 million over the next 22 years.

Under the terms of the swap contracts, the banks were owed up to $400 million in early 2009 when the city’s credit rating fell below investment-grade status. That could have triggered a bankruptcy filing then because Detroit couldn’t make the payment.

But former Mayor Ken Cockrel Jr. negotiated a deal pledging casino tax revenue as collateral instead. That converted the swaps into “secured” obligations, which means they must be paid off in bankruptcy. It also enabled UBS and Bank of America to insure their investment through Syncora Guarantee.

Trying to fix a bad deal

Syncora, which claims it should get the casino revenue, and other institutions holding Detroit municipal bonds object to the settlement. Other bond holders object because Orr has said they stand to lose a much larger portion of their investment than UBS and Bank of America.

If Rhodes rejects Orr’s proposed settlement with UBS and Bank of America, it might open another door for the city.

Jones Day attorneys, who represent the city in bankruptcy court, could then argue that the casino tax pledge was illegal and the swaps should be considered unsecured debt. In that case, the 75-cents-on-the-dollar offer is voided.

But — at least publicly in court — Jones Day attorneys are not pursuing that strategy.

Joseph Harris, the city’s chief financial officer when the casino revenue was pledged, said the city’s advisers didn’t raise any questions at the time about whether the casino pledge was illegal.

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“If we had not struck the deal, we wouldn’t be talking about this today — we would have been belly up in 2009,” Harris said. “We were dodging a bullet. We delayed what turned out to be the inevitable, and that is that the city would eventually default.”

The Michigan Gaming Control Board issued a letter in 2009 backing the pledge as legal, according to a deposition by Detroit investment banking adviser Kenneth Buckfire.

The law allows the revenue to be used for several purposes, including public safety spending, anti-gang programs, economic development and “other programs that are designed to contribute to the improvement of the quality of life in the city.”

“The pledge of the casino revenue to secure the city’s financial obligations is not even a ‘program,’ much less the type of city betterment program contemplated by the Gaming Act,” attorneys for a creditor called Ambac Assurance said in a court filing.

Representatives from UBS and Bank of America Merrill Lynch declined to comment.

All the lawyers wanted it

Like a blackjack player already deeply in the red, the 2005 deal was a dangerous doubling-down that pushed the city beyond its legal debt limit. To circumvent that requirement, Detroit created two subsidiaries run by city appointees to borrow the cash.

After Kilpatrick persuaded the City Council to sign off on the deal in 2005, city financial adviser Robert W. Baird & Co. bragged that it was a one-of-a-kind legal framework.

If Rhodes determines those subsidiaries, known as “service corporations,” were effectively just a pass-through way to fund the pensions, he could invalidate the pension obligation certificates, alleviating the city from $1.95 billion in principal and interest payments through 2035.

Former City Councilwoman Sheila Cockrel, who was serving on the council that — after several months of disagreement — unanimously approved the original pension borrowing deal in February 2005, said the structure was never questioned.

“There was nothing that ever suggested this was sort of a smoke-filled, back-room financial maneuver,” she said. “This was the mechanism that all the lawyers, bond lawyers, Wall Street laywers, Detroit lawyers — lawyers were all saying this was the way you do this.”